Commercial Mortgage Loans - National Association of Insurance ...

The NAIC's Capital Markets Bureau monitors developments in the capital markets globally and analyzes their potential impact on the investment portfolios of U.S. insurance companies. Please see the Capital Markets Bureau website at INDEX.

Commercial Mortgage Loans

Analyst: Steven J. Bardzik, Ph.D.

Executive Summary ? Commercial mortgages represent a significant portion of U.S. insurers' investment portfolios, matching long-lived, secured assets with stable, predictable cash flows with similar liabilities. For this reason, the greatest proportion by far of commercial mortgage loans are held by life insurance companies. ? Commercial mortgage loans amounted to approximately 9% of life companies' total invested assets. ? This primer represents an introduction to commercial mortgages, analysis of individual mortgages, and explanation and analysis of commercial mortgage portfolios.

Generally, What Is a Commercial Mortgage?

A commercial mortgage is essentially a private bond transaction between an insurance company and a borrower. The borrower may be a corporate entity (either private, limited liability company (LLC), non-public or public corporation) or individual. The borrowing is secured by a mortgage (or deed of trust), which pledges a property as collateral for the borrowing. The mortgage may be taken by the lender and sold at foreclosure to satisfy repayment of the debt in the event of default (nonpayment) by the borrower. The properties thus securing the transaction are generally commercial, income-producing properties, such as apartment, industrial, office, retail and hospitality (hotel) buildings. For insurance companies, they are typically high-quality, completed, well-located and operating stabilized.

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Types of Commercial Mortgages and Insurance Company Commercial Mortgage Portfolios in CRE Lending

Commercial mortgages made by life insurance companies are a distinct subset of the overall commercial real estate financing market. The overall commercial real estate (CRE) market is estimated at $4.1 trillion outstanding as of 2Q2018, of which $471 billion (11.5%) is held by life insurance companies (LICs). The major share of commercial mortgages, $2.2 trillion (52.7%), is held by commercial banks, with commercial mortgage-backed securities (CMBS) and government-sponsored entities (GSEs) at $375 billion and $306 billion, respectively, and certain other minor sources.

It is important to understand that LIC commercial mortgage portfolios are selectively composed of the best quality commercial mortgage in terms of construction, location, leasing and operational status, and general desirability. Their loans are selected for these qualities in order to support their generally long-dated maturities with a minimum of disruption. Since they are the highest quality commercial mortgages and thus the most desirable, there is intense completion for these loans. This competition drives their pricing, i.e., coupon rate of interest, lower; thus, the coupons of LIC commercial mortgages may be seen as a floor for interest rates on other riskier commercial mortgages. The quality of the LIC commercial mortgage portfolios is demonstrated by their significantly lower default rates over time.

Commercial banks, on the other hand, are ubiquitous and serve a wide commercial real estate clientele, both national and local. They can underwrite local properties, properties under a range of development, properties of an unusual or unique nature, and the borrowers and their capabilities to support the loan out of other sources. Thus, commercial banks can make other types of commercial mortgage (property-based) loans that may or may not have the established cash flow of properties suitable for LICs:

? Land acquisition and development. ? Property acquisition, development and construction. ? Property transition. ? Small commercial mortgage loans. ? Homebuilder loans. ? Unusual property types: golf courses, farms and ranch, restaurant and small hospitality. ? Shorter term loans. ? Loans for these property types secured by recourse to the borrower.

Accordingly, these loans generally will carry higher interest rates than LIC commercial mortgage loans to account for the increased risk. They often are floating rate to reflect the commercial

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banks' funding costs, and they often require recourse to and/or financial guarantees of the borrower.

Also, there is a range of "secondary financing" such as:

? Second and third mortgages on a specific property. ? Blanket mortgages (covering multiple properties). ? Cross-collateralization and cross default of multiple properties and loans. ? Mezzanine financing (wherein the security for the loan is a pledge of ownership

interests rather than a lien on the property).

LICs may make some of these loans from time to time as market conditions dictate, but these are not "bread and butter" LIC commercial mortgage transactions.

Commercial Mortgage Definition

Although "commercial mortgage" is the common terminology, a commercial mortgage is technically two contemporaneous documents: 1) a promissory note that evidences the borrowing; and 2) either a mortgage or deed of trust, either of which provides the lender access to the security collateral in the event of default by the borrower. The note contains the following terms:

? Date of loan. ? Amount of the loan, initial and subsequent fundings, if any. ? Interest rate; fixed rate or floating, including index, spread above index, reset dates, etc. ? Terms of amortization period or interest only. ? Maturity date of loan and provision for extension, if any. ? Prepayment penalties. ? Recourse to the borrower, if any. ? Payment specific terms.

The security for the loan is provided by either a mortgage or deed of trust. In both cases, the document pledges the specific property(ies) securing the payment of the note, which may be taken by foreclosure and sold to satisfy payment of the debt. There are technical differences between a mortgage and a deed of trust. Deeds of trust are considered to be a more expeditious means of taking the property. However, deeds of trust are only used in 16 states, as other states consider deeds of trust equivalent to a mortgage.

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Analysis of Commercial Mortgages I

Analysis of a commercial mortgage occurs at origination of the mortgage and throughout its life. The focus of the analysis is on the capacity of the operation of the property to: 1) generate the income necessary for the ongoing payment of the mortgage; and 2) maintain the value of property sufficient to insure repayment of the outstanding balance of the commercial mortgage at loan maturity (since commercial mortgage loans are usually not long enough to fully amortize).

The debt coverage ratio (DCR) is the key metric to measure the capacity of the operation of the property to generate the income necessary for the ongoing payment of the mortgage and is the first metric calculated. This is calculated by taking the annual rental income of the property and subtracting expenses to arrive at net operating income (NOI):

(Eq. 1) Debt Coverage Ratio = Net Operating Income / Annual Debt Service or, DCR = NOI/ADS (or = NCF/ADS)

A further step is to subtract certain other expenses such as allowance for capital improvements and leasing commissions to generate net cash flow (NCF). Then annual debt service (ADS) is calculated by calculating the monthly mortgage payment (given loan amount, interest rate and amortization period) and multiplying by 12 (months per year). The DCR = NOI/ADS (or = NCF/ADS). A DCR greater than 1 indicates excess capacity to pay the debt; a DCR less than 1 indicates insufficient capacity to service the debt. The higher the DCR above 1, the greater the capacity to absorb fluctuations in cash flow (i.e., loss of revenue from tenants.) For the most part, lenders look for a DCR well above 1, typically 1.2 or more. LICs will lend lower (i.e., more conservative) amounts in order to generate DCRs of ~1.5 and above, despite their generally lower interest rates.

The loan-to-value (LTV) is the second key metric calculated and indicates the margin of safety of recovery of principal (i.e., outstanding loan balance) in the event the borrower defaults. That is, upon foreclosure, could the property be sold for enough to pay off the debt? It is calculated by dividing the outstanding loan balance by the value of the property, or LTV = loan balance / property value:

(Eq.2) Loan to Value Ratio = Outstanding Loan Balance / Property Value or, LTV = OLB / Value

The loan balance at any point in time is readily calculable. Thus, the question is that of property value. The value may be provided by an appraisal, which is calculated by comparison of replacement (construction) costs, comparison of comparable properties sold and income capitalization. For income-producing properties, the latter approach is considered the most

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reliable, as it relates cash flow to current valuation of that cash flow in the market. The calculation is:

(Eq. 3) Value = Net Operating Income / Capitalization Rate or, Val = NOI / CR

The capitalization rate is derived from the sales price or valuations of comparable properties and their cash flows, adjusted for perceived differences. Although LTV ratios span the range depending on the type of loan, type of property, borrower, etc., generally lenders look for ratios below 1, indicating that there is sufficient value in the property to cover the outstanding loan balance; LTVs in the range of 70% to 80% may be considered reasonable. LICs prefer the safest, most conservative loans, so their LTVs are more usually in the 60% to 70% range. (Note also that the lower LTV requires less debt service, so lower LTVs generally result in higher DCRs.)

DCR and LTV are point in time calculations. Competent lenders (and equity investors) will develop a projected discounted cash flow (DCF) analysis to calculate these ratios annually throughout the life of the loan (or investment), typically 10 years or more. The DCF should incorporate the current level of leasing of the property (and vacancy) and the income generated, projected leasing and rental rate increases, additional income generated, current and projected market leasing, vacancy and rental rates in comparison to the subject property, the current and projected state of the real estate cycle, etc., thus generating projected DCR and LTV at each year through the life of the loan. Especially important is the projection of the capitalization rate used to value the income stream at mortgage maturity. Any potential source of refinancing the current mortgage will look to the then current income and valuation of the property for viability of refinancing. Unduly optimistic assumptions could jeopardize not only the current mortgage, but also its ultimate payoff. Optimally, throughout the life of the loan, the DCR should be increasing as income increases in relation to debt service, and the LTV should be decreasing as value increases (capitalized income increases) and loan balance is amortized.

A further measure of commercial mortgage loan performance is debt yield (DY). DY has become a more popular measure of an outstanding mortgage loan's capacity to be refinanced, as it relates income available to service the debt to the amount of debt to be refinanced. Theoretically, this should be increasing over time as operating income of the property increases and the loan balance declines with amortization. DY is calculated as:

(Eq. 4) Debt Yield = NOI / Outstanding Loan Amount or, DY=NOI / OLA

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